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posted on 29 August 2016

Monday Morning Call 29 August

Written by , Clarity Financial

Charts Suggest Higher Levels Of Caution

Despite a "belief" that "This Time Is Different (TTID)" due to Central Bank interventions, the reality is that it probably isn't. The only difference is the interventions have elongated the current cycle, and has created a greater deviation, than what would have normally existed. What is "not different this time" is the eventual reversion of that extreme will likely be just as damaging as every other previous bear market in history.

The chart below shows the S&P 500 back to 1925 with the long-term trend line overlaid with a 72-month (6-year) moving average and Bollinger bands. The bottom two graphs are the percentage of the band width of 2-standard deviations of the 72-month moving average and the 72-month W%R.

SP500-Chart4-082616

The vertical dashed lines correspond with corrections when both the %B and Wm%R both turn down from highs. While that has not occurred as of yet, it is unlikely at this point that it won't. It's just a matter of timing.

Furthermore, on a longer-term basis, the market continues within a "broadening topping process" or a "megaphone" pattern. While these patterns do not always come to fruition, the fact this one is combined with a dual sell-signals only registered prior to the financial crisis does provide some cause for concern.

SP500-Chart6-082616

One of the more "off-the-beaten-path" indicators I watch is the CBOE SKEW Index divided by the Volatility Index. This ratio has spiked in recent days and such spikes historically have led to either short-term corrective actions or more full-fledged bear market declines.

CBOE-SKEW-VIX-082616

Dana Lyons did a better job than I this past week with the Put/Call Ratio. To wit:

"However, even based on recent history, and even on a normalized basis, the August 23 reading was the lowest ever recorded.

So looking at the readings below 50, what can we glean, if anything?"

tumblr_inline_oci2km8XNp1sq14jh_500

"Again, as the chart shows, most of the readings occurred after at least a short-term selloff. They also marked almost the precise short-term bottom in the S&P 500 at many of the readings. Therefore, the performance of the index was generally very positive going forward. However, it is not all bull fodder, as the following table of previous incidents demonstrates:"

tumblr_inline_oci4imKOoI1sq14jh_500

"However, it is the 2 failed readings, and their similarity to current circumstances, that gives us pause in assuming an all-clear sign. Unlike the other events, those 2 failures, on 3/5/2015 and 8/12/2015, occurred in the absence of any noteworthy weakness. In fact, they were the only 2 prior readings that occurred while the S&P 500 was positive over either the previous 1 day, 4 days or 1 month. They were also the only 2 occurring with the S&P 500 within about 2% of its 52-week high.

Given the similar conditions presently to previous readings that failed, we'd have a hard time putting this into the bullish column."

Lastly, the weekly full-stochastic indicator as shown in the chart below has issued a "sell signal." Combined with the volatility index turning up from extremely low levels, it suggests a near-term potential for a continued corrective action.

SP500-Chart5-082616

While the market has managed to remain in suspended animation over the last couple of weeks, the market, on a short-term basis, remains in extreme overbought territory. This needs to be relaxed somewhat before additional equity exposure is added to portfolios. As shown, a reversion to the current bullish trend line, which coincides with the market's recent breakout levels, is a likely target in the short-term.

However, there is a more than reasonable chance, as I laid out two weeks ago, for a deeper correction in the next 30-days. The chart below shows the potential drawdowns from current levels.

SP500-Chart2-082616

History is working against the market. September is typically the weakest month of the year; since 1928, the S&P 500 has dropped in September 56% of the time.

MW-EU556_BAMLSe_20160823151206_NS

Here is the point. It would take a correction from current levels to break 2000, which is very important support for the markets currently, to even register a 10% correction.

Given the current bullish exuberance for the market, this is probably unlikely between now and the election. Therefore, even a "worst case" correction currently would likely be an 8.5% drawdown back to major support. Of course, for most individuals, even such a small correction would likely feel far more damaging.

The bottom line is there is a wicked setup being developed that could lead to a rapid destruction of capital if something "goes wrong" in the weeks ahead. With the risk/reward ratio very negative currently, caution remains advised.


Model Update

S.A.R.M. Sector Analysis & Weighting

Despite a bumpy ride this past week, the market actually declined by .57% last week. I know...SHOCKER...right?

As I have been repeatedly stating over the last few weeks, as boring as it has been, there has not been enough of a correction of the current overbought condition to justify increasing equity allocations in portfolios yet. This is despite the fact the model has been adjusted higher to represent the target levels of equity exposure we want to migrate toward.

While the portfolio equity risk weighting remains at 50% again this week, the odds of a further correction, as noted above, have increased this past week. The opportunity to increase equity allocations, given a sufficient setup where no violation of major support and the presence of an oversold condition occurs, has improved.

With all buy signals currently in place, and the bullish trend intact, this is not a market to bet heavily against...for now. However, it is also not a market to become extremely complacent in either.

Again, we must be given the right "set up" to increase equity allocations. Begin by "averaging up" in existing holdings to match model allocation and weights. When, and IF, the market confirms the continuation of the "bullish trend," then begin adding new holdings to the model.

(Note: This is an equally weighted model example and may differ from discussions of overweighting/underweighting specific sectors or holdings.)

SARM-ModelAllocation-082716

Relative performance of each sector of the model as compared to the S&P 500 is shown below. The table compares each position in the model relative to the benchmark over a 1, 4, 12, 24 and 52-week basis.

Historically speaking, sectors that are leading the markets higher continue to do so in the short-term and vice-versa. The relative improvement or weakness of each sector relative to index over time can show where money is flowing into and out of. Normally, these performance changes signal a change that last several weeks.

I noted last week:

"The fall in the US Dollar over the last could of weeks has boosted the performance of the energy, materials, and industrial sectors of the market. However, as stated above, we have likely gotten the majority of that advance already locked in so profit taking is likely wise."

That was a prescient call and the dollar bounced off support as anticipated last week. The recent spike in interest rates has now reached the top of the long-term downtrend and suggests that staples, utilities, and bonds will continue to improve in performance over the next couple of weeks. Such improvement will most likely coincide with an ongoing market correction.

SARM-RelativePerformance-082716

Notice in the next to last column to the right, the majority of all sectors and indices are pushing extreme levels of deviation from their long-term moving average. Such deviations can not, and do not, last long historically. A resolution of those deviations, which will occur during a corrective action, will provide the necessary risk/reward rebalancing to increase model allocations.

The two charts below graphically show the relationship of each position's performance relative to the S&P 500 Index. If we are trying to "beat the index" over time, we want to overweight sectors/asset classes that are either improving in performance or outperforming the index, and underweight or exclude everything else.

SARM-Rotation-082716

Sectors Currently Outperforming by >1%

  • None

Sectors Currently Performing In Line <>1%

  • Industrials

  • Materials

  • Energy

  • Staples (improving)

  • Technology

  • Financial

  • Discretionary (improving)

Sectors Currently Under Performing By >1%

  • Utilities (improving)

  • Healthcare (improving)

SARM-Rotation2-082716

Index/Other Asset Classes Out Performing S&P 500 By >1%

  • Small-Caps (weakening)

Index/Other Asset Classes Performing In-Line With S&P 500 <>1%

  • Mid-Caps

  • Equal-Weight S&P 500

  • International Bonds

  • High-Yield Bonds

  • Dividend Stocks

  • International Stocks

  • REIT's (improving)

Index/Other Asset Classes Under Performing S&P 500 By >1%

  • Emerging Markets (weakening - recommended sell two weeks ago)

The risk-adjusted equally weighted model has been increased to 75%. However, as stated above, a pullback in the markets is needed before making any changes.

SARM-ModelPorfolio-082716

Such an increase will change model allocations to:

  • 20% Cash

  • 35% Bonds

  • 45% in Equities.

As always, this is just a guide, not a recommendation. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance, time frames, and goals.

For longer-term investors, we still need to see improvement in the fundamental and economic backdrop to support the resumption of a long-term bullish trend. Currently, there is no evidence of that occurring.


THE REAL 401k PLAN MANAGER

The Real 401k Plan Manager - A Conservative Strategy For Long-Term Investors


401k-PlanManager-082716

NOTE: I have redesigned the 401k plan manager to accurately reflect the changes in the allocation model over time. I have overlaid the actual model changes on top of the indicators to reflect the timing of the changes relative to the signals.

There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

Everything In Slow Motion

As I stated last week:

"It seems as of late that we have continued to wait on an event that seems as if it will never come. Such is the trial of money management and a disciplined approach to investing over the pull of emotional biases.

Sometimes, it seems, we get the "feeling" that we should do "something." Yet, as I try and detail here in this missive often, sometimes the best way to do "something" is to actually do "nothing." Such is the case now."

I wish I had something new to report to you this week, but unfortunately, I don't.

  • The Fed came and went. The market barely noticed.

  • Economic data continued to weaken. The market barely noticed.

  • The dollar and interest rates rose. The market barely noticed.

This keeps us currently stuck with the risk of "doing something" greatly outweighed by the potential reward of "doing nothing."

As discussed at length in the above missive, we certainly want to prepare ourselves to increase equity exposure in portfolios, however, we must patiently wait for the right conditions to apply those increases. Furthermore, while waiting for the relaxation of prices to make more prudent entries, it also enables investors to bypass potential "head fakes" of market actions.

Continue to do "something" by managing the inherent risk in your portfolio by:

  • Reviewing the allocation model adjustments below

  • Identifying the next course of actions in your 401k-plan

  • Waiting to make adjustments until technical conditions improve.

  • Changing allocations to target levels when conditions are right.

If you need help after reading the alert; don't hesitate to contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principal. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

401k-ModelTarget-071616

401k Choice Matching List

The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don't see your exact fund listed, look for a fund that is similar in nature.

401k-Selection-List

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